Jim Rickards

Following what the Federal Reserve is doing is key to understanding what is going on in the markets.

It’s a wish that central banks would go back to being boring institutions that took care of money supply and acted as lender of last resort, instead of monstrosities that manipulate and invade every corner of every market in the world.

Unfortunately that’s what we have.

When you manipulate the US dollar interest rates you are directly or indirectly affecting every market in the world — equities, gold, other commodities, junk bonds, corporate bonds, etc.

WILL THE FED RAISE INTEREST RATES?

The Federal Reserve has signaled that they intend to raise rates – no question about that.

That’s what the FED has signaled and that’s what the markets expect.

Securities around the world — equities, bonds etc. — are prices as if the FED is going to raise rates. It’s never been more advertised and more trumpeted.

The last time the Fed raised rates was in 2006.

They hit bottom in terms of cutting rates in 2008, when they got to zero, and it’s been at zero ever since.

So it’s going on nine years since the last time they raised interest rates — that’s a long time without a rate increase. People forget how nasty they can be.

Jim was in the markets in 1994 when the Fed raised rates, and it was a wipe out. We had the bankruptcy of Orange County, California, dealers went out of business, and it was a bond market massacre.

The same thing happened when the stock market crashed in October 1987 — dropping 22% in a single day.

But before that, in March 1987, there was a bond market crash. The bond market crash preceded the stock market crash by about six months.

These things can be nasty. That’s why the Fed is talking about it so much.

If you go back to May 2013, when the Fed was still printing money and buying bonds (the Fed calls it Long Term Asset Purchases), Bernanke started talking about tapering. They didn’t do anything — didn’t cut purchases or raise rates — they just talked about it and the market threw a fit. They didn’t actually taper until 2014.

They’ve been advertising an interest rate rise for two years and there’s a reason for that.

Why were they zero in the first place?

The Fed was trying to pump up assets. They wanted banks and other borrowers to borrow cheap money and buy houses and stocks (assets) — to bid up the price and create a wealth effect.

They wanted to make people feel richer, so they would go out and spend money and get the economy on a self sustaining path.

That didn’t happen.

The price of assets went up but the wealth effect didn’t kick in. The economy is still very weak, and the Fed didn’t get the 3 1/2 – 4% growth that they were hoping for.

If the Fed had it to do over, Jim thinks they wouldn’t go down this path, or at least not for so long.

But, because they had encouraged everyone to borrow money overnight in the repo market, to go out and buy some risk, and do maturity mismatches, they wanted to give people lots of warning, saying, “We’re going to raise rates.”

If I’m a dealer, I can go out overnight and by a 10 Year Note in the repo market, which until recently was about 2%. So I have zero cost on my borrowing and make 2% on my 10 Year note. But I can leverage that trade 10 to 1, because I can get more than 90% margin in the repo market. So a 2% profit, leveraged 10 to 1 is a 20% return on equity, with a government security as my asset.

As long as rates were at zero, it was pretty easy to make 10 – 30% return on equity with a highly leveraged trade.

You might say that’s too easy — where’s the risk?

There’s no credit risk in the trade because you’ve got a Treasury as your asset.

The risk is that if the Fed raises short term interest rates while you’re sitting there with overnight money holding a 10 Year note, then all of a sudden the overnight money gets to be more expensive — the trade is upside down and you’re losing money.

So the Fed encouraged everyone to do these crazy carriage trades and maturity mismatches to try to build the banks balance sheets, and now gives them time, years really, to get out of the trade, or mark it down, or hedge it.

So if anyone is caught then it’s shame on them — they can’t say they weren’t warned.

The Fed wants to raise rates to normalize things.

But there’s still a lot of leverage in the system so the market isn’t listening to the warning. There’s enormous leverage in the stock market and various carriage trades around the world.

So Jim believes it might throw the economy into a recession. Some have listened and some are still in for a rude awakening.

We’ll have a bumpy ride without a soft landing.

Beyond that, the Fed raising rates is based on a forecast for a stronger economy, but no one has a worse forecasting record than the Fed.

When the Fed says it believes the economy is healthy enough for a rate increase, it’s the first sign that it’s not.

IF THEY RAISE RATES

If they raise rates there will be disruption. Not only will people stay in the leveraged market too long but the Fed has the forecast wrong. It would throw the economy close to a recession, more deflation, and disruption in equity markets. The one market that might rally is the 10 Year bond market.

IF THEY DON”T RAISE RATES

Jim doesn’t believe they will raise rates in 2015. He’s basing that on what the Fed says publicly — they said it’s data dependent.

The Fed has a dual mandate — lower unemployment and create price stability.

You can’t always do both at once, but the one thing you can look at that can tell you about both is Real Wages.

Real wages are going down. There’s nothing in the data to indicate a reason to raise rates.

If they don’t raise rates then maybe the market will start thinking that they can never raise rates. It wouldn’t surprise Jim to see QE4 in early 2016.

The stock market might rally by the end of the year based on the free money.

By then the inflation will start to ratchet up which would be good for gold.

The second half of 1015 might see a rise in gold and stocks for the same reason.

INFLATION VS DEFLATION

We have inflationary and deflationary forces going on at the same time. They are pulling in a tug-o-war.

There’s enormous tension but no movement at the beginning, and it’s not clear until the end who wins, when one team is pulled over the line.

Reasons for Deflation:

1. Demographics – work forces are aging and spending less
2. Technology – more technology use means less use of people like assistants
3. De-leveraging – because of excessive debt from 2008 still being worked out

Reason for Inflation:

Money Printing – all the central banks, the Fed, ECB, Bank of England, Bank of Japan, and Peoples Bank of China, are all printing fiat money

The Peoples Bank of China has printed more money than the Fed in the last five years.

The inflation of money printing is pulling against the deflation of demographics, technology and de-leveraging.

Right this minute deflation is winning — we see it in oil and commodity prices.

But central banks have to have inflation so they have to try harder. They have to print more.

If you knew we’d have inflation then you’d know what to do. You’d buy some gold, some art, some hard assets, and you’d get out of cash.

If you knew we’d have deflation then you’d also know what to do. You’d keep cash and buy bonds.

The problem is that we have both inflation and deflation.

So the best thing to do right now is to have a balance of both.

You won’t win in all those trades but you’ll win on a lot of them, and at least you won’t get wiped out when the rope gets pulled over the line and there’s a tidal wave of force.

That’s a barbell approach — and it’s the approach Warren Buffett has.

We don’t know how this is going to turn out and you should be prepared for both.

CREDIT CRUNCH IN CHINA

There’s already a credit crunch in China going on in slow motion, and it’s being finessed by the central bank. Real estate prices in China are in full scale decline.

There’s a trillion dollar Ponzi scheme called Wealth Management Products (WMP). When a middle class Chinese person makes a deposit at the bank they get zero interest, so instead they go into a WMP that pay 5 – 7%.

But the WMPs aren’t guaranteed by the bank, and the money goes to real estate projects that have been building empty cities and empty train stations.

That’s starting to implode. China has $4 trillion in reserve so they can bail it out, but it’s still very costly.

STRONG US DOLLAR

There’s a credit crunch going on all over the world and it’s partly because of the strong US dollar.

Two sets of borrowers are going into distress:

1. The Energy Sector

Trillions of dollars was borrowed on the assumption that oil would be over $80 per barrel, and some assuming oil at over $100 per barrel. Now it’s about $45. A lot of those corporate bonds are going to default.

2. Emerging Market Corporate Debt (Not Sovereign Debt)

Companies in places like Mexico, Brazil, Indonesia, Turkey, South Africa, Russia and elsewhere, borrowed US dollars. They can’t print money because they aren’t central banks, and a lot of their business is done in their local currency, so they have to buy more expensive US dollars to pay off their debt.
It might take a year to play out, but if the price of oil doesn’t correct then they won’t be able to pay their debts.

That’s trillions of dollars in defaults from energy related and emerging market debt.

It’s ten times bigger than the subprime market was in 2007, and if even 10 – 15% default then it will be bigger than the subprime defaults.

GOLD

Everything is priced in terms of something else, and gold is usually looked at relative to the US dollar.

Gold in 2014 was down slightly against the US dollar but up against every other currency in the world. It was the second best performing currency in the world. Bitcoin was the worst.

The US dollar is strong because it’s a flight to safety from other currencies, including a flight from China before it collapses.

People are buying stocks, bonds and gold, which many think of as a dollar denominated asset.

Gold and the dollar pulled away from all the other currencies in 2014.

MINING

In the long run, when the price of gold goes up then they mine more. But in the short term they don’t increase production because gold mining is a very capital intensive, long horizon business.

Gold has been volatile. So if it goes up then they want to see it stay there for a year or two before increasing production.

If gold is at a higher sustained level then there will be more mining and more output. But that can take years and won’t change the price of gold in the short run.

While we’re not at ‘peak gold’, but there are reports that say it’s getting harder to mine and you have to go deeper down — some mines are a mile deep.

Gold will go up exponentially — 300, 400, 500% — in the face of a new financial crisis, which Jim expects.

Leaving that aside, if things are steady then gold will trend higher and mining output won’t change that in the short run.

JAPANESE STYLE DEFLATION

The US is already seven years into a multi-decade Japanese style deflation and central banks cannot tolerate deflation.

There’s too much debt.

The way the United States gets out from under its debt is by inflation — basically stealing the money from the creditors by making the money worthless.

It’s been done many times, but most famously in 1933 when the price of gold increased 75%.

When the stock market fell 90%, the one stock that went up was Homestake Mining, a gold mine.

JIM’S MOTIVATION AND INSIDER INFO

Jim wrote his books because he meets with officials in the Federal Reserve, including Reserve bank presidents and members of the board of governors. He meets with people in the national security community and the Pentagon. He’s been a guest at the Treasury, and has been invited in for seminars, and to give presentations behind closed doors to risk management groups.

He’s happy to do work with the government — some is paid and some is volunteer work, which also involves recruiting other volunteers.

Jim was called upon to help after 9/11, and spent time in Pakistan earlier in his career where he was involved with Islamic banking.

Spending time with all of those officials made Jim become aware that the people in-the-know always win.

They win because they can see what’s coming.

It bothered Jim that everyday Americans didn’t know what was coming.

He hated the idea that people’s money could be stolen from them because of policy.

Jim understands the policies, and he believed that there was a place for a book that was written in plain English.

His books are PhD level content written in plain English.

Even if people aren’t interested, Jim knows that he said it and tried to level the playing field, and to get people some insight into how the policymakers are thinking.

The new album, Preparing for the Fall, is now available on iTunes at $9.99 for the album and $.99 for singles. The album includes the singles Wag the Dog, Black Swan Dive and The Gods of the Copybook Headings.